Picture of the Day: Inflation

Or why Ben Bernanke is telling congress that the Fed is more worried about unemployment and growth than inflation.   HT: Economix.

Ah, but what about expected inflation you say (as any good macro student should), well here you go:

The picture is messed up, but I am too old and technologically incompetent to fix it. Sorry.

Ho ho!! Look at this old dog figuring out how to fix it. I converted it into a PDF and then back into a JPEG. That got the white background I needed. I know, Photoshop. But I don't have photoshop. What I have are my wits and they are fading fast...

Crisis-o-nomics: Gold, Inflation and the US Dollar

While I was in Brazil, a former student sent me an e-mail with this question (sorry for taking so long to answer it):

"I'm curious what your opinion or knowledge is of currency commodities like gold and silver in inflationary or deflationary periods. Does gold or silver really hedge against the risk of inflation by giving similar purchasing power over time while a paper currency is losing purchasing power over time? I've been thinking over some issues revolving around these ideas a lot in light of our current economic situation. It seems as if there is a possibility for some high inflation in the near future. Will the infusion of capital into the market through different means such as the economic bailouts cause inflation? Also, as consumer confidence lowers and international confidence in the dollar is lost - the desire to hold something other than dollars would flood the supply and cause inflation of the dollar, right?"

This is a great and timely question, in fact, Bloomberg just today has an article about the surge in gold prices.

First let's address the question of gold as a hedge against inflation. Before I start with this, let me just say that right now, I am more worried about deflation than inflation. While it is true that loose monetary policy (and it is as loose as we can make it at the moment) could ignite inflation, we generally look at wages as the key channel, and with unemployment going berserk I am not expecting wages to be going up any time soon.

Okay, so there is some truth to the idea that gold has some 'intrinsic' value: it is awfully pretty and malleable so works well for jewelery, it is a good conductor and doesn't corrode, so good for electronics, etc. And there is only so much of it in the world and mining adds to the total stock of gold about 2% a year (from one estimate I have read) so it does not, in general, keep up with average growth. That is to say, there is a fundamental demand for it more than just because it is pretty and there is a limited supply which means that there is a sense in which its value is secure. But one must be careful with this logic, for the demand for gold can fluctuate wildly for many reasons, one of them being investors trying to hedge against inflation. Below is the 30 year dollar gold price graph. Notice that during the high inflationary period of the late seventies gold prices skyrocketed, but they collapsed almost as quickly after Volcker put the clamps on the money supply.
So if you got it just right and bought gold in Jan 77 and sold in Jan 80, you did really well, but if you bought in 80 and sold later, you did not. Another thing to keep in mind is that we have learned many lessons from the late seventies loose monetary policies, and should not ever expect a repeat of that again. Monetary policy for the last 25 years is almost always first and foremost used to keep inflation low and predictable. By the way, notice that gold has risen quite a lot in the last few years, partly because of the huge pools of money looking for outlets, partly because of high industrial and consumer demand and partly because of the relatively weak dollar. So buying now (while the price is already high) does not to me seem like a very good bet. As soon as the panic subsides, people will be looking for investment opportunities and pulling out of gold.

The next question is whether the bailout plans could ignite inflation. Well, in theory yes, but the economic situation is so terrible right now, even though we are talking about potentially billions of dollars being spent, it is still unlikely to do much more then staunch the bleeding. There will come a time, however, when the recovery begins, lots of hiring happens along with lots of new investment and this will be the crucial time for the Fed to keep money loose enough to allow this to happen robustly, but not too loose as to cause high inflation (higher than 3%).

The third question is about whether loss of confidence in the US and in the Dollar will lead to Dollar depreciation. Yes, we should see a loss in the Dollar in general when the US economy goes south, interest rates in the US are near zero so there are better returns elsewhere, etc. But, up until just recently we have actually seen an appreciation in the Dollar. This is coming from the fact that, one, the credit crisis is so terrible, people are hoarding their cash and putting it in the safest place on earth: US Treasuries which are Dollar denominated. And two, that this economic downturn is global, so while the US economy is tanking, so are most of the rest of the major economies in the world. So there really isn't a lot of competition for the Dollar right now.

So, I don't recommend investing in gold if you are worried about inflation and trying to protect yourself from a high inflationary episode. If you want to do this, there are extremely effective ways that come straight from the US government: Treasury Inflation-Protected Securities (TIPS). But, in general I would not be worried about inflation at the moment - I would be (as I am) deeply distressed about the potential for a deflationary episode. I believe we need fiscal stimulus big time and right away.

Econ 101: Inflation, Exchange Rates and Commodities

Though I try and stick more to the local and the personal in this blog, I thought it might be a good time to try a little primer on international finance, as I just taught it in my international economics class. Call it the "what the heck is going on?" post.

I am going to borrow a pedagogical device right out of Krugman and Obstfeld's outstanding text and start with an asset either in Europe or the US. What determines the performance of this asset? Well, interest rates and inflation if you are investing domestically. If you are investing from abroad, however, exchange rates matter as well. But it is not what the state of the world today that matters most for the performance of an asset, it is what the state of the world will be in the future - when the asset matures - that matters most. Thus expectations about inflation and exchange rate movements matter a lot. This is why central banks have become more and more transparent: they are trying to manage expectations. This is also why central banks have become, first and foremost, inflation hawks: they want to guarantee low inflation lest investors get jittery.

So let's get back to that asset. Suppose you are in Europe and you have money to invest and you are thinking of investing in either a euro denominated asset or a US dollar denominated asset. If interest rates in the US are high, you might be tempted to invest in the dollar asset, to do so you want to sell euros and buy dollars so you can purchase the asset. Since many investors are making the same calculation the demand for dollars will be driven up and demand for euros will be driven down. This will lead to an appreciation of the dollar. Higher interest rates in Europe, all else equal, will have a similar effect: the euro should appreciate against the dollar (or dollar depreciation). Inflation in either zone will lower the real return on the asset and thus will have the same effect as lowering the nominal interest rate and thus high inflation in the US should lower the demand for dollar assets and lead to a depreciation of the dollar. Finally, expectations about exchange rates can lead to them being self-fulfilled: if you expect the dollar to depreciate this leads to a lower demand for dollar assets (because when it matures the dollars you get out are now worth less) and thus a lower demand for dollars and - hey presto! - a dollar depreciation.

With this basic framework in hand, it is not surprising that the US dollar has depreciated so remarkably over the last few years - the fed kept interest rates low which both lowered the return on dollar assets and caused a bit of concern about inflation. Here is a picture of the dollar-euro exchange rate for the last five years:



Commodities play in interesting role here, especially if they are dollar denominated (which most are). Generally when the US dollar depreciates it makes US products sold abroad cheaper to the residents of those foreign countries. It also makes foreign products more expensive in the US. This generally leads to more exports being sold and fewer imports being bought which - in the US - would generally lower the trade deficit. However oil is a dollar denominated commodity, and since we import a lot of it, our trade deficit is actually going up (see graph from NY Times). Since oil prices are set in a futures market they are a function of expectations of future supply and demand and exchange rates. So questions about future supply and a weak dollar have pushed up oil prices dramatically, something we are seeing filter down to the gas pump. There could also be quite a bit of speculation as well, but it is not yet clear that this is the main culprit. Add to this the fact that food prices are climbing ever higher and that the crop year does not look to be particularly bountiful and you have even more pressure on inflation.

So where does this leave us today? Well, the US is in the midst of a major economic slow-down sparked by the credit crisis. The credit crisis, while still needing a long time to shake out, looks to have been largely tamed by some bold action by the Fed. Now we are faced with some unpleasant realities for the near future. The price of oil is starting to seep into core (non-energy and food) inflation. If wages start to respond (which as of yet they haven't), we could be in for a major inflationary episode. This will cause the dollar to further decline which will mean even higher oil prices. Yikes. So regardless of how the credit market is currently faring, the Fed will almost certainly have to start to raise interest rates. Doing so will quell inflation expectations and drive up demand for dollars which should start leading to an appreciation of the dollar. But it will also cause a slow down in domestic investment at the very time we want more of that to happen. Still the risks are much worse: once wages start adjusting to inflation, the Fed will have to respond much more drastically to keep inflation under control.

So, over the next 12 to 24 months I think we are in for a very tough time. The Fed will almost definitely start to raise interest rates, appreciating the dollar and taking some pressure off commodities prices. This will, unfortunately, curtail credit at the very time we are trying to get credit flowing again which will lengthen the malaise in the housing market. So right now the Fed knows it needs to stay on top of inflation but definitely does not want to jump the gun as the longer they with the more the credit markets can recover before increasing rates. I think we are likely in for a long and painfully slow recovery.

Hold on to your hats...

Economist's Notebook: Why Do Mortgage Rates Rise When the Fed Cuts Rates?

This is a question that often perplexes people and it was asked again this week in the Sunday Oregonian to a mortgage broker who basically punted on the answer. She said: "The drops by the Fed do not directly affect long-term, 30-year rates. They do directly affect short-term rates, consumer and auto loans, that sort of thing." Um, OK, but back to the question, why did mortgage rates go up when the federal funds rate target dropped? The answer is complicated. Into the pricing of mortgages go things like risk, expectations of the performance of the economy, etc., but the one of the big ones is expected inflation. It is easy to see why - inflation quickly erodes the return on long-term loans. So what are inflation expectations doing? Let's ask the Cleveland Fed who tracks it. Here is a graph of adjusted 10-year Treasury Inflation-Protected Securities (TIPS):



From the Cleveland Fed: "Because the market's expectations for inflation are priced into one of these securities, the measure that is derived from the yields is a good estimate of the market's estimate of future inflation."

We see that since the late fall inflation expectations have risen steadily. In December and January mortgage rates fell steadily, perhaps thinking that the Fed was on top of this trend, but then mortgage rates jumped back up - right around the last two rate cuts, on Jan 22 and Jan 30. I think it is pretty clear that the mortgage market suddenly started to worry quite a bit about the Fed loosing control of inflation (below is a graph of 30 year fixed interest mortgage rates).